How Default Minimum Payments Lead to More Credit Card Debt

Journal of Marketing Research Scholarly Insights are produced in partnership with the AMA Doctoral Students SIG – a shared interest network for Marketing PhD students across the world.

From its origins as a metal plate in the Charga-Plate bookkeeping system to the digital versions available today, the credit card has gone through a fascinating evolution over time. Modern credit cards serve many purposes: They are not only a placeholder for making payments but they also offer benefits such as accumulating airline miles, securing loans, and receiving priority status for specific services. Recently, brands like Aspiration have begun offering carbon offsetting incentives to qualifying customers. However, although cardholders enjoy the benefits of payment management, they are also racking up starling amounts of credit card debt. Recent market analyses revealed that U.S. credit card debts reached an alarming $930 billion, which surpasses the $870 billion peak during the 2008 recession (White 2022).

To help credit cardholders avoid debt accumulation, credit card companies offer a default option of making a minimum payment, whereby the cardholder pays a small fraction of the overall amount due every month instead of making the entire payment at once. However, a recent Journal of Marketing Research study shows that the automatic minimum payment option can have the unintended consequence of causing the cardholder to accumulate more debt. The authors suggest that, by choosing automatic minimum payment as a default option, cardholders neglect to make larger payments, even if they had done so previously. This results in an overall increase in accumulated debt. Using detailed transaction data, the authors show that approximately 8% of all of the interest ever paid is due to this effect.

By choosing automatic minimum payment as a default option, cardholders neglect to make larger payments, even if they had done so previously. This results in an overall increase in accumulated debt…The authors show that approximately 8% of all of the interest ever paid is due to this effect.

Luckily, the authors find that if consumers are provided with a prompt to make payment in full or pay a larger amount, the negative psychological effects of automatic minimum payments are mitigated.

As this topic has important implications for consumers, marketers, and policymakers alike, we reached out to the authors with a few questions to gain a deeper understanding of the effect of default options on consumer behavior.

Q: How did you identify the need to research the effects of a default automatic minimum payment? What inspired you to start working on this interesting idea?

A: The work was initiated in response to the UK regulator’s credit card market study. Direct debits (or autopay in the U.S.) struck us as people self-selecting into a default, and we have a program of work to examine the long-term effects of defaults and other nudges. So, just because people avoid fees in the short term doesn’t mean that the overall objective—improved financial well-being—is a given. So, we look at the long-term effect on the level of all fees paid. Another example of this approach is discussed by Adams et al. (2018), where we find that nudging people away from automatic minimum repayment works well in that people switch to new repayments, but it ultimately appears to make no difference to financial well-being across the portfolio of cards they hold.

Q: How do you anticipate that paying off credit card debt in full rather than just the minimum payment defaults will affect people’s purchasing habits?

A: If people are roughly in a steady state, with consumption and debt static month to month, then they are just using the debt to live a few months ahead of their income. Paying credit card debt in full would need to be funded from increased debt, reduced consumption, or reduced savings. If people are co-holding savings and debt, this might make sense, provided they retain sufficient liquidity. If people can cut consumption for enough time to pay down the debt, this could also make sense, as the debt is not cheap. But for many, the debt is too large, and consumption is already pared back, so it would be very difficult. Collectively, credit card debt is very large and so paying it off all at once would likely have significant consequences for the economy.

Q: More than 60% of the sample in Study 1 used manual payments (p. 779). What motivates most consumers to use manual payments in your opinion? What role can marketers play in reducing apprehension about financial technology?

A: There are several issues here. Inertia may mean people never quite get around to setting up an automatic payment. People may also choose manual repayments to have greater control over their cash flow. Given the costs of going overdrawn on one’s current (checking) account, a large bill that might appear unexpected but is paid automatically is not desirable. Indeed, if credit cards are used to smooth over lumpy income or expenditure, automatically paying in full kind of defeats the point. Maybe people rightly fear financial technology. Often, it is not set up with consumers’ best interests as the primary objective. Strong regulation is important.

Q: Do you believe that providing rewards like cash back or discounts for full payments will have a more significant impact than the nudges looked at in the study?

A: Yes, it seems likely that stronger incentives to pay down credit card debt would be effective. But this raises the issue of who is paying for the cost of my credit card if I pay in full and get incentives for doing so. Yes, the card provider gets some money from the interchange fee charged by credit card companies to merchants, but this is not a huge amount. Given the slim margins, it seems unlikely the financial incentives could be that large.

Q: How do you think nudges from third parties like the “financial tips from Credit Karma” will mitigate the effect of anchoring on the minimum payment?

A: Tally was inspired by our work on balance matching (Gathergood et al. 2019). I think there is room for third parties to help arbitrage a portfolio of finances. It is likely that removing the minimum payment option and allowing people to reflect and choose another amount will lead to fewer minimum repayments. But the U.S. Card act didn’t have much effect when repayment scenarios were introduced, which highlights the importance of randomized controlled trials ahead of, or along with, the introduction of a new policy, no matter how well meant.

Q: You mention in the paper that “default exists in many areas of individual choices.” How do you think financial companies misuse such defaults, and what is the possible win–win solution for both consumers and firms?

A: How many people have an autopay (“direct debit” in the UK) for something they do not need or want anymore? There is bound to be a fraction of automatic transactions that are no longer in consumers’ interests, even if they once were. So yes, I think there are lots of products that rely on people getting stuff wrong to make money and incorrectly forecasting what they will do. Indeed, Save More Tomorrow™ was explicitly designed to take advantage of known weaknesses in behavioral economics to encourage people to save more in their pensions, and it worked. Though this had a positive intent, if used for evil, the same methods will work. For example, teaser rates have been commonplace for years in retail offers. The Financial Conduct Authority (the UK regulator) has launched a new UK consumer duty, where known behavioral biases are not to be exploited in designing new financial products. If these biases are used for good, as was intended with Save More Tomorrow, banks can help consumers achieve their goals, building a stronger relationship with their customers. But they have to be in it for the long term.

Read the full article:

Hiroaki Sakaguchi, Neil Stewart, John Gathergood, Paul Adams, Benedict Guttman-Kenney, Lucy Hayes, and Stefan Hunt (2022), “Default Effects of Credit Card Minimum Payments,” Journal of Marketing Research, 59 (4), 775–96. doi:10.1177/00222437211070589

References:

White, A. (2022, December 20). Credit card debt in the U.S. hits all-time high of $930 billion-here’s how to tackle yours with a balance transfer. CNBC. Retrieved December 28, 2022, from https://www.cnbc.com/select/us-credit-card-debt-hits-all-time-high/

Adams, P., Guttman-Kenney, B., Hayes, L., Hunt, S., Laibson, D., & Stewart, N. (2018). The semblance of success in nudging consumers to pay down credit card debt. Financial Conduct Authority Occasional Paper, (45).

Gathergood, J., Mahoney, N., Stewart, N., & Weber, J. (2019). How do individuals repay their debt? the balance-matching heuristic. American Economic Review, (109), 844–875. https://doi.org/10.1257/aer.20180288

Go to the Journal of Marketing Research